Investment and Finance Key Terms: Risk, Return, and Diversification

Investment

An asset purchased with the goal of providing additional income from the asset itself, but with the risk of loss.

Return

Profit or income generated by saving and investing.

Investment Risk

The possibility that an investment will fail to pay the expected return.

Risk-Return Trade-Off

Higher potential returns come with higher risk (chance of loss).

Liquidity

How quickly and easily an asset can be converted to cash.

Savings Tools

Monetary assets that are liquid (easily converted to cash).

Investment Tools

Investment assets that may not be easily converted to cash or may have penalties for early withdrawal.

Purpose of Investments

Usually used to pay for long-term goals such as buying a house, higher education, or retirement.

Recommended Savings/Investment Rate

At least 10% of net income should be dedicated to savings and investments.

Saving vs. Investing - Risk and Return

Saving = low risk, low return (0-4%); Investing = higher risk, higher return (8-12%).

Rate of Return Formula

Total Return ÷ Amount Invested = Rate of Return (expressed as a percentage).

Example of Rate of Return

$110 ÷ $2,200 = 5% rate of return.

Inflation

A rise in the general level of prices.

Inflation Risk

The danger that money won't be worth as much in the future as it is today.

Goal vs. Inflation

Strive to have a rate of return higher than the rate of inflation.

Bond (Lending Investment)

A form of lending to a company or government that pays fixed interest until maturity.

Maturity Date

The specified time in the future when the bond's principal amount is repaid.

Stock (Ownership Investment)

A share of ownership in a company; owners are called stockholders or shareholders.

Dividend

A share of a company's profits distributed in cash to stockholders.

Capital Gain

Unearned income received from selling an asset above its purchase price.

Real Estate

Ownership of residential or commercial property or land; can generate income through rent or capital gains.

Speculative Investments

High-risk investments (e.g., futures, options, collectibles) with potential for large fluctuations in return.

Mutual Fund

A company combines funds from many investors and invests them in a diversified portfolio of stocks and bonds.

Advantages of Mutual Funds

Reduces investment risk and saves investors time.

Disadvantages of Mutual Funds

May charge high fees.

Diversification

Spreading money among a variety of investments to reduce risk.

Index Fund

A type of mutual fund that invests in stocks and bonds making up a specific market index (e.g., S&P 500).